Thursday, August 10, 2017

Housing: Part 249 - It's all about rent.

I have posted graphs before that show how rent has become an increasingly important factor in home prices at the MSA level, before, during, and after the housing boom. They are near the end of this post.

Today, I thought it might be helpful to look at that graph in terms of Price/Rent and Rent. Here it is.

Source: Zillow

The relationship between the median Price/Rent and the median annual Rent of an MSA just keeps getting stronger. And the reason is that MSA housing supply limits are the primary factor influencing housing markets today.

What causes this relationship? I can think of three potential connections:

1) Where rents are high, it is the result of limited housing in cities where that obstruction to migration allows incomes and rents to continue to rise. Expected rent inflation raises the value of those homes.

2) Where rents are high, the income is from economic rents that come from political exclusion, not from capital allocation. The value of housing units, then, accrues to land, not to improvements. Land does not depreciate, so Price/Rent levels are bid higher because landlords require lower gross returns on their properties.

3) Where rents are low, housing supply is elastic, which means that low long term real interest rates might increase the present value of homes, but they also induce new building, which pushes down rents. This makes housing in elastic cities less sensitive to real long term interest rates. There is little supply response in cities where rents are high. This means that when long term real interest rates decline, there is no mitigating effect on rents. This allows home values to be more sensitive to low long term real interest rates, as we would expect a very long-lived real asset to be.

Whatever the reason, until we can actually have a conversation that acknowledges rent as the fundamental factor here, analysis of the housing boom and bust will be less than useless. Right now, there are schools of thought among economists divided between the "credit supply" school and the "credit demand" school. Both schools of thought are based on the premise that rent had nothing to do with changing home prices, so entire papers written on this topic don't even mention rent at all. This is really crazy, because if you go talk to residents in San Francisco, New York City, etc., they are complaining about the rent! And the hundreds of thousands of households that either move away from those cities each year or refrain from moving in are largely renters with lower incomes. They are fleeing from cities with lucrative income opportunities because of the rent. This is such an overwhelming factor in our current economic context, it simply can't be denied.

And, yet, entire seminars among economists are based on erasing this from the set of priors.

Meanwhile, while every guy at the end of the bar and every internet amateur Austrian economist agrees that economics is useless and that economists were complicit in the errors that led to the Great Recession, the one thing they all seem to agree on is that economists have this totally right! Prices are irrational and have nothing to do with rent.